Thursday’s policy meeting is a golden opportunity for the European Central Bank to promote the long-awaited reset of Europe’s fiscal-monetary mix. Too often in the past, especially during the euro area upheavals in 2010-12, the response to crisis was overwhelmingly monetary. The central banks were left ‘the only game in town’ with little or no support from fiscal action. For many in the ECB governing council, this has gone on for too long.
There is huge pressure for the ECB under Christine Lagarde to act on Thursday to counter coronavirus effects. However, commitments to wholesale easing from its new president would be neither sufficient nor credible. Instead, a coordinated and targeted fiscal response is needed. If anyone needs to issue ‘whatever it takes’ messages, it should be finance ministers, not central bankers.
Markets appear to be pricing in a further 0.1 percentage point cut in the ECB’s minus 0.5% deposit rate, with many expecting additional easing measures such as targeted liquidity to small and medium-sized enterprises or expansion in the €20bn-a-month quantitative easing through bond purchases. But as last week’s Federal Reserve experience shows, central bank attempts to show it can manage the situation by itself can backfire. The reality is it cannot.
A conventional rate cut à la Fed would do little to support small- and medium-sized enterprises struggling to pay wages and suppliers. While a rate cut could initially lower the euro to a more favourable rate against the dollar, the exchange rate is not a target for the ECB. And, given current interest rate levels and the constraints of the ‘zero lower bound’, the US would probably win a tit-for-tat currency war. The ECB should think carefully before joining a race to the bottom.
While some ECB governing council members have expressed support for expanding targeted longer-term refinancing operations channelling cheap bank financing into key sectors, others are more sceptical. They argue that such measures can take time to prepare given high complexity. They can also be less effective as they are more demanding in terms of targets and impose strict restrictions on participants. The ECB’s objective under present circumstances is not to increase demand in specific sectors, but to ensure that the overall system remains operational.
One option would be to provide liquidity through absorbing extra debt from member governments by increasing the ECB’s monthly asset purchases to €30-40bn. This would allow the ECB to continue QE before reaching the issuer limit with the existing debt stock. Another step would be temporarily to shift purchases to countries such as Italy with higher yields, through a variant of the ‘flexible, yield-contingent approach to interventions’ studied in 2016. Raising the issuer limit would be one way to expand bond purchases. This may, however, not be necessary if governments issue more debt to support fiscal measures. Italy has already announced a €7.5bn euro package, and Germany has followed with stimulus measures too. The US, though, has once again been ahead of the curve with big possible policy announcements, such as a temporary payroll tax cut. Coordinated fiscal action is planned at a European level. And there may be some legal flexibility on the issuer limit. According to one senior Eurosystem official, ‘If the ECB wished to reconsider the legal interpretation of the issuer limit, then this would be the situation to do so’.
David Marsh is Chairman of OMFIF. Danae Kyriakopoulou is Chief Economist and Director of Research at OMFIF.